The old adage of “Don’t put all of your eggs in one basket” is as good a description of “diversification” as there is. In the context of investing, diversification is a way to obtain a desired risk/reward balance in an investment portfolio. This is done by spreading around the components of an investor’s portfolio so that such investor’s exposure to any one type of asset is limited. This practice is designed also to help reduce the volatility of a portfolio over time.
The process of deciding how to apportion an investor’s portfolio is called asset allocation, which involves deciding how much of a portfolio is invested in various asset classes (and within asset classes). There are four primary classes of assets:
- Cash (or cash equivalents);
- Alternative assets.
To achieve diversification, investors will blend dissimilar assets together so that their portfolio does not have too much exposure to one individual asset class or market sector.
The first step in portfolio diversification is to make allocations among the four listed primary asset classes. This step necessarily takes into account the risk tolerance of the investor. As a general rule, the younger an investor, the more risk tolerant that investor should be since that investor should have a longer time horizon to absorb risks associated with volatility.
Of the four primary asset classes listed, stocks are most likely to be considered the most risky and subject to the most volatility. Cash (and cash equivalents), on the other hand, would be considered the least risky since there is nominal volatility for these (except for the effects of inflation). Considerations for asset allocation among these classes would include
- The time horizon for a need for current liquidity (such as buying a house or paying for a wedding) or, conversely, a far-in-the-future need to pay for college in the case of a young parent;
- Impending or current retirement (where the investor should be more risk adverse);
- Risk-tolerance of the investor, where a person who is anxious about money (and the risk of losing it) would be far less tolerant of risky investments.
The matter of asset allocation not only applies in the context of divvying up assets as between the four primary asset classes but also within each of these classes. As one would expect, there are stocks, for example, that are more risky than others, discernible by higher P/E multiples and/or higher volatility indices (represented by Beta, which measures volatility relative to the stock market, and it can be used to evaluate the relative risks of stocks).
In short, diversification reduces overall risk while increasing the potential for overall return. That’s because, in any particular year, some assets will perform well while others will perform poorly. Yet over the next year their positions could very well be reversed — with the former laggards becoming the new winners and vice versa. Regardless of which assets are the winners, a well-diversified investment portfolio tends to earn the market’s average long-term historic return.
Alternative investments are one of the four primary classes of assets as identified above, and must necessarily be considered to round out an investor’s investment portfolio. So, what are alternative investments? Alternative investments are investments that, well, are alternatives to the other three asset classes. They fall primarily in two buckets. First are private assets such as private equity, private credit and commodities, as well as transportation, infrastructure and real estate assets.
These types of alternative investments are more complex and less frequently traded than public stocks and bonds, and give investors access to additional sources of return. The second bucket of alternative investments are hedge funds; these operate mainly in public markets but use less traditional tools such as short-selling and leverage.
At access, we offer investors the opportunity to diversify their portfolios in the alternative investment class of investments that are represented in the first bucket described above. More specifically, access offers alternative investments that consist of transportation, infrastructure and real estate assets, as well as private credit in the form of loan interests. Looking, then, at this wide range of alternative investments that access will bring to market, these investments will feature the following key attributes that should enhance an investor’s’ benefits from diversification:
- Low volatility (that is, price stability);
- Industry diversification (airlines, railroads, shippers, etc.);
- Asset diversification (aircraft, railcars, ships, etc.);
- Sub-asset diversification (Boeing vs. Airbus, widebody aircraft vs. narrowbody, coal railcars vs. pellet carriers, etc.);
- Credit diversification (within industries and outside of industries);
- Geographic diversification (North America vs. Europe vs. Asia, etc.);
- Risk/reward diversification; and
- Diversification of transaction tenor.
A critical aspect of investor diversification into the types of assets that access offers is that our investments have a rather low correlation to the volatility of assets in other markets. When the stock market is down, for example, we expect that our alternative investments will hold their value. This feature in particular, as well as the other features listed above, enables an investor to enhance his investment portfolio by reducing overall risk while increasing the potential for overall return.
Some of your eggs belong with access.